The Bull Bear Trader discusses market events and news with an interest in understanding risk and return in both bull and bear markets. Discussion topics include trading and hedging strategies, derivatives, risk management, hedge funds, quantitative finance, the energy and commodity markets, and private equity, as well as an occasional investment opinion.

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.